Market Overview

Feds Circling SAC Capital; Mathew Martoma Goes Down in $276 Million Insider Trading Sting

Feds Circling SAC Capital; Mathew Martoma Goes Down in $276 Million Insider Trading Sting

Another bombshell dropped on Tuesday in the sprawling insider trading investigation being run out of Preet Bharara's office. The U.S. Attorney for the Southern District of New York unveiled an indictment against former SAC Capital portfolio manager Mathew Martoma accusing him of trading on inside information.

According to the government, the illegal tips allowed SAC Capital to reap profits and avoid losses of $276 million, making it the largest insider trading case ever. The conduct alleged in the indictment is nothing short of shocking and egregious.

It is alleged that Martoma sold massive amounts of Elan (NYSE: ELN) and Wyeth shares in the days leading up to the release of key drug data for the two companies in July 2008. The stock sales came after the trader was tipped off that the drug in question, an Alzheimer's treatment known as bapineuzumab, was not as effective as had been expected. Even more shocking, the government alleges that the illegal information came from an octogenarian doctor who served as the chairman of the safety monitoring committee overseeing the clinical trial.

Martoma, 38, who was a trader for an affiliated SAC Capital hedge fund known as CR Intrinsic, is the sixth current or former SAC employee implicated in insider trading violations. He has been charged with conspiracy and two counts of securities fraud. He allegedly cultivated a relationship with a renowned University of Michigan neurologist named Dr. Sidney Gilman, 80, who subsequently provided Martoma with highly lucrative inside information.

The two were introduced to one another through a so-called "expert networking" firm. According to Bharara, over the course of around 42 consultations at $1,000 an hour, Martoma convinced Gilman to share information on the drug trial he was working on. Furthermore, the two reportedly became friends and Gilman treated Martoma like a colleague and pupil.

On Gilman's advice, Martoma built up a large stake in both Elan and Wyeth, which was subsequently acquired by Pfizer (NYSE: PFE). Billionaire trading legend and SAC Capital founder Steve Cohen also acquired large stakes in the companies based on Martoma's recommendation. The pivotal drug data which would substantially effect the price of the two stocks was set to be presented by Dr. Gilman on July 29, 2008.

Prior to the presentation, Dr. Gilman was provided with an encrypted 24-page PowerPoint document which revealed that the drug's efficacy was well below expectations. In fact, the data showed that bapineuzumab failed to halt the progression of Alzheimer's in patients in the clinical trials.

According to the Feds, Gilman subsequently spoke with Martoma for around 1 hour and 45 minutes and actually sent the PowerPoint presentation to the trader along with the password needed to access it. Gilman has been charged civilly by the SEC, but has entered into a non-prosecution agreement with the government and is not named in the criminal indictment. He is cooperating with the Feds.

At this point, Martoma and Cohen, who is referred to as "Portfolio Manager A" in the indictment held a roughly $700 million position in the two stocks. Specifically, the firm had acquired around $365 million in Elan shares and $335 million in Wyeth shares. This was a very substantial position, even for SAC Capital. Even more significant is the fact that the drug data was expected to be a binary outcome -- either good or bad -- with a dramatic move in the stock price in either direction.

Suffice it to say, that even in the hedge fund world, this kind of bet was seen as bizarre and risky. In fact, other SAC traders had expressed concern over the size of the position given the unpredictable nature of clinical drug trials.

When Martoma saw the leaked data, he realized he was in trouble. When the information became public, his and Cohen's positions would be buried. Upon learning the news, Martoma allegedly emailed Cohen, asking “Is there a good time to catch up with you this morning? It's important." Subsequently, the two spoke for around 20 minutes on a Sunday.

The following day, Cohen instructed his head trader to begin liquidating the fund's position in Elan and Wyeth and “to do so in a way as to not alert anyone else, inside or outside of the hedge fund." The indictment does not specify the nature of the discussion between Martoma and Cohen other than to say that Martoma expressed that he was no longer comfortable with the positions.

Cohen has not been charged and it is unclear if he was aware of the nature of Martoma's information. That certainly will be a question that the Feds will want answered and it is likely that they are pressuring Martoma to flip on his former boss if Cohen did indeed know about his inside source. In any event, after the conversation between Cohen and Martoma, SAC Capital began executing a very large liquidation order in Elan and Wyeth shares using dark pools and trading algorithms.

Dark pools are trading venues where large investors can execute trades anonymously away from the exchanges. The platforms do not identify the brokers and institutions who are trading on the system and orders are hidden until a transaction is completed. Trading algorithms break up large orders into smaller chunks and then efficiently hunt for liquidity to execute against. The purpose of these tools is to cloak the trading activity of large investors such as SAC Capital so that other market participants cannot sniff out their orders and front-run them.

“This was executed quietly and effectively over a 4-day period through algos and dark pools and booked into two firm accounts that have very limited viewing access,” the head trader wrote to Cohen on July 27, 2008. “The process clearly stopped leakage of info from either in or outside the firm and in my viewpoint clearly saved us some slippage.”

While the liquidation of $700 million in stock just days ahead of the release of key drug data might have raised some red flags, what SAC did next was truly shocking. The firm, on the advice of Martoma, began shorting Elan and Wyeth. Portfolios managed by SAC subsequently went from being $700 million long Elan and Wyeth to around $260 million short in the matter of days.

Prior to the July 29 announcement, the firm was short 4.5 million Elan shares and 3.3 million Wyeth shares. According to the government, the reasoning for the flip-flop is pretty obvious -- Martoma knew exactly what was going to happen.

This type of trading activity by itself is extremely suspicious. In fact, the government's case, is the absolute best explanation for it. Selling or trimming the positions ahead of the trial data would have been understandable. Selling $700 million in shares and then going short to the tune of $260 million basically overnight, on the other hand, looks suspicious. Its amazing that Martoma even attempted this.

When the data was released on July 29, both Elan and Wyeth plunged. Readers should pull up a chart of Elan, in particular. The stock fell 42 percent on the news and has never recovered. Wyeth lost 12 percent. SAC Capital and Mathew Martoma's portfolio made millions off of the bearish positions that were allegedly established with insider information.

In the short-term, the whole thing turned out unbelievably well for Mathew Martoma. At the age of 34, he reaped a $9.38 million bonus for the year. Subsequently, however, Martoma lost money for the firm in 2009 and 2010. In May 2010, he was terminated on the recommendation of a SAC Capital employee who called him a "one-trick pony with Elan" in an email.

Despite losing his job, the trader was, by all accounts, living the good life prior to Tuesday morning when the FBI came knocking at 6:30 in the morning. After leaving SAC, Martoma secured a job at Boston-based hedge fund Sirios Capital, although it is unclear if he is currently still employed.

The government caught up with him at his $2 million Boca Raton home which he shares with his wife, who is a pediatrician. The Mediterranean-style house is equipped with a luxurious pool and even an elevator, according to the New York Post which called it a "country club estate." The couple even has a foundation which was funded with nearly $1 million.

Basically, it seems like Martoma was living on Easy Street after his big score at SAC. Now, he faces a potential 20-year sentence in Federal prison and will be pondering his future while out on a rather steep $5 million bail.

In the wake of the charges, Martoma's lawyer immediately went on the defensive. “Mathew Martoma was an exceptional portfolio manager who succeeded through hard work and the dogged pursuit of information in the public domain,” his attorney, Charles Stillman, said in an e-mailed statement. “What happened today is only the beginning of a process that we are confident will lead to Mr. Martoma's full exoneration.”

The second part of this story will focus on the other former SAC traders that have been ensnared in the government's sprawling investigation, the history of Steve Cohen, and an analysis of what exactly the Feds are up to in relation to SAC Capital. Stay tuned.


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